Question

Ghost, Inc., has no debt outstanding and a total market value of $382,500. Earnings before interest and taxes, EBIT, are projected to be $52,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 14 percent higher. If there is a recession, then EBIT will be 23 percent lower. The company is considering a $190,000 debt issue with an interest rate of 7 percent. The proceeds will be used to repurchase shares of stock. There are currently 8,500 shares outstanding. The company has a tax rate of 25 percent, a market-to-book ratio of 1.0, and the stock price remains constant. a-1. Calculate earnings per share (EPS) under each of the three economic scenarios before any debt is issued. (Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.) a-2. Calculate the percentage changes in EPS when the economy expands or enters a recession. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) b-1. Calculate earnings per share (EPS) under each of the three economic scenarios assuming the company goes through with recapitalization. (Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.) b-2. Given the recapitalization, calculate the percentage changes in EPS when the economy expands or enters a recession. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) a-1. Recession EPS Normal EPS Expansion EPS a-2. Recession percentage change in EPS Expansion percentage change in EPS 96 %

Answer 1

Answer : a-1) Calculation of EPS under each economic scenerios :

Below is the table showing calculation of EPS :

EPS = Earning Available for equity shareholder's / Number of equity shares outstanding

	Normal	Expansion	Recession
EBIT	52000	59280 (52000 * 1.14)	40040 (52000 * 0.77)
Earnings for equity shareholders [EBIT * (1 - tax rate)]	39000 [52000*(1- 0.25]	44460 [59280 * (1 - 0.25)]	30030 [40040 * (1-0.25)]
Number of shares outstanding	8500	8500	8500
EPS	4.58823529411 or 4.59	5.23058823529 or 5.23	3.53294117647 or 3.53

a-2) Calculation of percentage change in EPS :

% change in EPS from Normal to expansion = (5.23058823529 - 4.58823529411) / 4.58823529411 =14%

% change in EPS from Normal to recession = ( 3.53294117647- 4.58823529411) / 4.58823529411 = (-23)%

b-1) Calculation of EPS in case of recapitalization:

Before calculating EPS we need to calculate that after raising debt the nuber of shares repurchased :

Number of shares repurchased = Debt Value / Price per share

Price per share = Market value / Number of shres outstanding

=382500 / 8500

= 45

Number of shares repurchased = 190000 / 45

= 4222.2222

Number of shres outstanding after repurchase = 8500 - 4222.22

= 4277.78 or 4278

Below is the table showing calculation of EPS :

EPS = Earning Available for equity shareholder's / Number of equity shares outstanding

	Normal	Expansion	Recession
EBIT	52000	59280(52000 * 1.14)	40040(52000 * 0.77)
Interest Expense ( Debt * Interest rate)	-13300	-13300	-13300
Earnings Before Tax (EBT)	38700	45980	26740
Earning After Tax [EBT * (1 - tax rate)]	29025	34485	20055
Number of shares outstanding	4278	4278	4278
EPS	6.78506493506 or 6.79	8.06142857144 or 8.06	4.68818181819 or 4.69

b-2) Calculation of percentage change in EPS :

% change in EPS from Normal to expansion = (8.06142857144 - 6.78506493506) / 6.78506493506 = 18.81%

% change in EPS from Normal to recession =(4.68818181819 - 6.78506493506) / 6.78506493506 = (-30.90%)